On April 17, 2019, the Department of Treasury issued the second set of proposed regulations regarding the Qualified Opportunity (QO) Zone Program. This long-awaited guidance further clarifies how to comply with the program and how to make it over some of the hurdles associated with structuring related transactions.

While there is much more detail in the proposed regulations, which we will delve into in future posts, below addresses the top questions we have received from clients to date.

1. What Does “Substantially All” Mean, and Why Does It Matter?

To be considered a QO Zone business, “substantially all” of the tangible property the business owns or leases must be QO Zone business property. One of the requirements for business property to be considered QO Zone business property is that during substantially all of the QO Zone Fund’s holding period of the property, substantially all of the use of such property was in a QO Zone. If a QO Zone Fund owned a partnership interest or stock, the partnership or corporation needs to be a QO Zone business during substantially all of the QO Zone Fund’s holding period of the partnership interest or stock.

Until now, substantially all was not defined. The new set of proposed regulations define substantially all as 70% or more for the use of property in a QO Zone and 90% or more for the holding period test.

This is an important definition for investors to understand because QO Zone Funds that fail the 90% test are subject to a harsh penalty that quickly erodes the benefits of the program.

2. Can a QO Zone Fund Sell QO Zone Property and Reinvest the Proceeds in Other QO Zone Property without Tax Consequences? How Much Time Does the QO Zone Fund Have to Reinvest the Proceeds?

Treasury could find no authority for the QO Zone Fund to avoid recognition of the gain from the sale or disposition of the qualifying investment. This means taxpayers will be taxed on the gain from the sale of the asset but the original deferred gain and holding period of the QO Zone Fund interest are unaffected.

The proposed regulations provide a 12-month exception to the 90% test (penalty) for proceeds received by a QO Zone Fund from the sale or disposition of QO Zone business property, QO Zone stock and QO Zone partnership interests — provided the proceeds are held continuously in cash, cash equivalents or debt instruments with a term of 18 months or less. Accordingly, the QO Zone Fund has 12 months from the date of distribution, sale or disposition to avoid the penalty. After the initial six-month 90% testing date, the subsequent testing dates are June 30 and December 31. So, if the 12-month period falls outside of a testing date, the QO Zone Fund would have until the next testing date to redeploy the proceeds into another qualifying investment.

3. In an Indirect Investment Structure Involving a Partnership, Can the Project Entity Refinance the Property and Distribute Refinance Proceeds to the QO Zone Fund, and Ultimately to its Investors, without Impacting the Deferred Gain?

Maybe.

If the fair market value of the distribution does not exceed the partner’s tax basis in its qualifying QO Zone Fund partnership interest, it is not an inclusion event and does not impact the deferred gain. Alternatively, if the fair market value of the distribution does exceed the partner’s tax basis, it would be an inclusion event and reduce the deferred gain.

Another option to avoid the inclusion event would be to have the QO Zone Fund reinvest the refinance proceeds into other QO Zone business property.

4. Can a Business Located in a QO Zone that Sells Products to Customers Outside of a QO Zone be Considered a QO Zone Business?

Assuming the other requirements of Section 1400Z-2(d)(3)(A)(ii) are met, the proposed regulations provide three safe harbors to determine whether a sufficient amount of income is derived in a QO Zone for the purposes of meeting the 50% gross receipts test. The gross receipts test requires:

At least 50% of the services performed by employees and independent contractors are performed within the QO Zone (based on hours), or

At least 50% of the services performed by employees and independent contractors are performed in the QO Zone (based upon amounts paid for the services), or

The tangible property of the business located in a QO Zone and the management or operational functions performed for the business in the QO Zone are each necessary to generate 50% of the gross income of the trade or business.

If the business can meet one of these tests, it can be considered a QO Zone business. However, the proposed regulations also include a facts and circumstances test that allows a business to qualify even if any of the three safe harbors are not met.

5. Can Leased Property Qualify as QO Zone Business Property?

Certain leased property may be considered QO Zone business property. The leased property must be:

Acquired under a lease entered into after December 31, 2017, and

Substantially all (70%) of its use must be in a QO Zone during substantially all (90%) of the period for which the business leases the property.

The leased property does not have to meet the original use test. Leased property is also not required to be leased by an unrelated party. The lease terms must be a market rate lease.

This provision provides building owners located in a QO Zone who either recently renovated their building, or where renovation isn’t necessary, to have another bite at the apple for this program. It provides an incentive for businesses to relocate their businesses into a QO Zone to obtain the benefit of the program. Time will tell whether landlords can use this incentive to structure 10-year leases.

If the lessor and lessee are related, there are two additional hurdles a QO Zone Fund must overcome for the lease to be considered QO Zone business property:

Prepayments by the QO Zone business to the landlord cannot exceed 12 months of use,

In the case of leased tangible personal property, the QO Zone Fund or business must acquire other tangible QO Zone business property with a value equal to that of the leased property by the earlier of either the last day of the lease or the end of the 30-month period beginning with the inception of the lease.

6. If an LLC Sells a Building at a Profit, Does the Gain Automatically Qualify for the Program? If So, When Does the 180-day Period Begin?

Whether or not the gain will qualify will be based on the answers to the following questions:

Is any of the gain required to be recaptured as ordinary income due to depreciation recapture rules under Sections 1245 and 1250? If so, then that portion of gain does not qualify because it is not treated as capital gain.

Does the owner have any other Section 1231 losses during the tax year the building was sold? If so, only the net Section 1231 gain would qualify for the program. Section 1231 assets are not defined as capital assets, but the proposed regulations provide that gains treated as capital gains are eligible. Taxpayers would need to net their 1231 gains with losses to determine the amount of eligible gain.

Does the owner have any unrecaptured Section 1231 losses? There is a special rule for Section 1231 gain that requires its recharacterization from capital gain to ordinary income if there were Section 1231 losses in any of the five preceding years.

Regarding timing, the proposed regulations clarify the 180-day period for Section 1231 gain begins on the last day of the tax year. This is important to note because investors cannot make a qualified investment into a QO Zone Fund until they have experienced a capital gain. This rule may make it administratively difficult for large QO Zone Funds to line up investor capital because investors in Section 1231 gain will need to wait until the end of the year to invest.

7. Can a Developer Who has Structured a Portion of Their Return as a Carried Interest Still Benefit from the Program, Assuming They hold Their Interest in the QO Zone Fund for 10 Years?

No. The proposed regulations clarify that investments in QO Zone Funds must be in cash or property, not services. A carried interest is considered a mixed-funds investment and not eligible the benefits of the program.

This second round of regulations offer more clarity to the QO Zone Program, helping investors, businesses and ultimately communities reap the benefits.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.